Long-term fixed interest rate loans are a very common type of financial instrument. The most common example of such loans are home mortgage loans. Many home loans are based upon fixed interest rates and have a repayment period of 10 years or more. Many automobile loans are also based upon fixed interest rates, though the repayment periods are generally shorter, typically 3-5 years.
A fixed interest loan represents an inherent risk for a bank or other lending institution. Market interest rates may fluctuate up or down from the interest rate locked in by the consumer at the time the loan is made. When market interest rates go down, the lending institution stands to make money if the consumer continues to hold the loan. However, consumers are likely to refinance in this situation, and thus, prepay the loan in its entirety.
When interest rates go up, the lending institution stands to lose money. In this situation, a consumer will likely not refinance a loan, so prepayment through refinancing will not often occur. Some customers will prepay the loan because they have sold the financed real estate, but most loans will not be prepaid in this way.
It would be useful for a loan holder to have a way to induce customers to prepay portions of loan balances when interest rates have risen and are higher than the interest rates on the customer's loans.